Where Does Leverage Come From?

As traders graduate from spot trading to using leverage either through margin trading or futures contracts, they invariably ask themselves “Where or who is providing the leverage?” When in doubt, ask the Bitcoin community on Reddit. The resulting answers usually display the general Bitcoin public’s lack of understanding of how leveraged trading works. This post is meant to explain how leverage is granted when trading on margin and with futures contracts.

Margin Trading

Margin trading is the next step above spot trading in sophistication. When trading on margin you post collateral and someone lends you additional funds to purchase Bitcoin. Assume you have $100 and wish to purchases $1,000 worth of Bitcoin. To complete the trade you need to borrow an additional $900. Various Bitcoin exchanges operate parallel markets where traders in need of additional funds can borrow from other users. You borrow $900 from the market at an interest rate. The additional leverage was provided by someone with excess USD, and in return you pay interest.

Your loan has an expiry date. Once it matures, you must obtain another loan at a different interest rate, or close your position. If you intend to hold the levered position for a long period of time, you have interest rate risk. If rates rise substantially, a significant amount of your equity could go to paying interest, which could lead to the premature closure of your position. Using the above figures, if it cost you 1% per day to borrow $900, you would pay $9 per day in interest. In 12 days, you $100 equity would vanish if the price stayed flat.

Regardless if you make a profit or loss, you must pay back your loan. To ensure that you always have enough equity left to pay back the loan, the exchange will set a maximum leverage threshold. If due to losses on your position you breach this minimum threshold, the exchange will automatically close your position and return the principle back to the lender.

Futures Trading

Once you have the hang of margin trading, futures trading is next. Like margin trading, trading futures involves leverage. Unlike margin trading you do not borrow funds from another user, but the leverage set by the futures exchange. If you wanted to go long futures contracts worth 100 Bitcoin, the exchange would require you to deposit 30 bitcoin or 30% (BitMEX requires 30%, each exchange is different). Both the long and the short would deposit 30 Bitcoin. Trading futures contracts is a zero sum game, you can only win what the loser has deposited as margin. So if there were no other traders, your maximum gain would be 30 Bitcoin or 30%. Futures contracts trade on a separate order book, whereas with margin trading you trade on the spot order book. The job of the futures exchange is to bring enough traders together so that the system has enough funds to allow the price of the futures contract to trade at any level.

In margin trading, your holding period is determined by the maturity of your loan. With futures trading, your maximum holding period is determined by the maturity of the futures contract. The price of the futures contract vs. the price of underlying spot determines the implied interest rate. If you bought a one month futures contract at $110, but the spot price of Bitcoin was $100, you paid 10% interest to borrow funds for the leverage. With futures contracts you know the term interest rate up front, and this rate is locked for the entire duration of the contract.

The futures exchange will specify the minimum amount of equity you must maintain. If you breach this threshold, the exchange will close a portion or all of you position. They do this to ensure there is enough equity so settle all outstanding contracts at maturity. The more leverage the exchange grants, the harder it is to ensure orderly settlement of outstanding contracts.